Slide 2: Course Overview In many organizations, inventory represents the single largest investment and one of the largest assets that the company owns. Since it is such a large piece of the operation, i f not properly planned and controlled, the investment can become a liability rather than an asset.
The main reason an organization maintains an investment of inventory is to compensate for either a disconnect with the current requirements or to act as buffer stock between supply and demand. If the
company cannot supply the product as fast as the customer demands delivery, it must maintain an inventory balance to have the product ready when the customer demands it. If it wishes to maintain production efficiency related to operations or machines that run at different speeds, it must maintain
inventory between them to meet the demand of each. This course covers inventory concepts within a business, such as levels of inventory management,
classifications of inventory, inventory storage techniques, methods of tracking inventory, and verification of inventory accuracy. The course also discusses issues related to inventory planning, such as components of inventory costs, safety stock, replenishment methods, and techniques related to order quantity.
Slide 3: Course Objectives After completing this course, you should be able to:
Discuss concepts important to inventory management.
Use the ABC principle to establish the appropriate level of control for groups of items.
Control inventory through proper storage and tracking practices.
Control inventory through record accuracy and properly determined inventory value.
Explore the factors that must be considered when planning inventory levels and replenishment.
Slide 4: Lesson 1: Explore Inventory Concepts
Slide 5: Lesson Introduction Inventory is classified and controlled at two general levels within an organization: the aggregate level and the item level. In addition, two commonly used methods related to the classification of inventory exist. One is based on the flow of material throughout the organization, and the other relates to the function that the
After completing this lesson, you should be able to:
Identify common inventory classifications.
Answer the questions addressed by item inventory management.
Explain how significant part numbers can be used in item inventory control.
Discuss the importance of physical inventory identification.
Identify inventory classification groups.
Explain how materials flow from the supplier to the manufacturing facility to the customer.
Explain how supply and demand affect inventory.
Identify the five basic functions of inventory.
Slide 6: Aggregate Inventory Management Introduction Aggregate-level inventory management is the planning and controlling of groups of items. Management sets medium- to long-range goals, typically in monetary values, for groups of items and tracks the progress
in meeting these goals. Since these plans cover a long period and are for the entire organization, inventory information is more useful for decision making when it is in aggregate form.
Aggregate inventory control involves classifying the inventory to allow management to compare the actual performance to the targets and determine whether corrective actions are required. A number of common aggregate inventory classifications exist.
Flows and Kinds of Inventory With classifications such as raw material, work-in-process (WIP), finished goods, distribution inventory, or
maintenance, repairs, and operating supplies (MRO) inventory, aggregate inventory management enables management to determine if the level of inventory for each classification is consistent with the overall plan.
Patterns of Supply and Demand Inventory is viewed in terms of quantity and dollars as it flows from the supplier, through WIP, and then to the customer. Management can see how inventory decisions affect profits or customer service.
Functions that Inventory Performs Classifying inventory by its function allows management to compare the amount of inventory in each
function with the plan. Inventory Management Objectives
Management has established t arget levels for each classification of inventory. Separating the inventory into classifications enables analysis and decision making.
Costs of Acquiring and Maintaining Inventory The only reason to carry inventory is that it costs less to carry it than to acquire precisely what is needed when it is needed. Comparing the cost to carry and the cost to acquire allows management to see if costs
Slide 7: Item Inventory Management Item inventory management deals with the control and planning of individual items in inventory in both monetary value and physical terms. It addresses four questions.
Which items are most important?—Many factors can be considered in determining which items are most important to the organization. Commonly used factors include the money spent on items over a period of time, the relative importance to customers, the profits generated by an item, and the
amount of critical resources used to make or store the item. The answer to this question will heavily influence the answers to the other three questions.
What is the appropriate level of control for each item?—The most important items warrant a higher
degree of control than do the less important ones. The controls include the physical access to the item, transaction reporting, frequency of ordering, and the quantity ordered.
How much of an item should be ordered at one time?—Knowing how much of an item to order at
one time is a question of balancing the cost of ordering an item with the cost of holding the item in inventory.
When should a replenishment order for an item be placed?—Management control involves
ordering the item so that it does not run out balanced against knowing that if it is ordered too soon, carrying costs occur.
Slide 8: Part-Numbering Systems Product identification for a specific item consists of both a numbering scheme and the actual physical identification of the product.
The first decision encountered when setting up a new inventory system is whether you want to build meaning into your part-numbering scheme, and if so, how much? Significant part numbers have historically been the method of choice; however, recent trends lean toward nonsignificant part -numbering schemes.
Significant part numbers have been popular for two reasons. Both reasons are related to limited memory. First, individuals do not have to remember the description or name of an item. Everyone can use the part
number and communicate meaning. Second, early computers had limited memory and computing power, so it was not practical to classify parts in many different ways and then group them by classification.
Logic that can be built into a part number includes product group identification, vendor identification, customer identification, or product specifications such as dimensions, weight, color, or flavor.
Slide 9: Physical Identification of Inventory The methods used for the physical identification of materials should also be considered very carefully.
Physical identification can include everything from a SKU label on a small parts bin or large container for bulk materials, to individual product packaging or labels, to compliance case labels, to pallet license plates.
Typically, when an organization maintains the inventory control of an item or part number, it treats each item
with the same part number as interchangeable in terms of inventory. However, there are some instances where inventory must be maintained by a specific production date or purchased date. This process requires
extensive additional procedures and controls for record keeping above normal inventory control. For example, if a commercial airplane crashes, the owner of the airplane must be capable of providing for
each component the name of the manufacturer and the date it was produced.
Slide 10: Classifications of Inventory To manage and make decisions about inventory, we need to classify the inventory. Inventory can be classified based on the following factors, including:
Whether the item is made in-house or purchased and what the associated cost is.
Who is responsible for the item.
The material from which the item is made, such as steel or brass.
Commodity codes, or what family to which the item belongs.
The flow of material through the organization.
Storage requirements of the item, such as ambient or temperature-controlled.
The function that the inventory serves.
The importance of the item.
Other inventory classifications are used in specific situations. Protective inventory is a theory of constraints classification. Protective inventory is kept to ensure that the constraint in the system can achieve the
desired level of throughput. Vendor managed inventory is a class of inventory for which the supplier is responsible for maintaining the inventory level to meet an agreed upon range of use.
In this course, we will focus on classifying inventory according to the flow of material through the organization, the function that it serves, and the relative importance of the item.
Slide 11: Inventory Flow One method of classifying inventory is the flow of the material from the supplier through the manufacturing
facility to be prepared for shipment to a customer. The flow is closely aligned with accounting, as the initial investment in inventory and expenses related to the transformation of goods are not recovered until the finished product or service parts are sold. Therefore, purchased items, raw materials, work -in-process, and
finished goods represent negative cash flow, while the sale of the final product represents positive cash flow.
It is important to note that goods can move from stored inventory to work-in-process inventory and back several times in the production of complex products.
Slide 12: Inventory Flow (Cont.) Introduction Let’s examine each component in the diagram in detail.
A purchased item is sourced from a supplier. An example would be the brass coupler attached to the end of a garden hose.
Raw Material Inventory Raw material inventory includes all purchased parts and direct materials that go into the end product. A n example would be the compound used to manufacture the casing of a garden hose.
MRO Inventory Maintenance, repair, and operating (MRO) inventory comprise items that are not directly associated with
the manufacture of a product. MRO inventories include office and operating supplies that typically have a low value per unit. They also include parts that are vital to keeping production equipment operating or are vital to the production process, even though they don ’t become part of the product. Solvents used to clean
circuit boards and industrial gases used in the production process are both examples. Work-in-Process
WIP is inventory that is in the process of being transformed into final products. Raw materials are released from inventory and moved to a work center. People—direct labor—and machines are used to add value by putting the parts together as subassemblies, assemblies, and then into final products. For example, once
the hose has been manufactured, the brass coupler needs to be attached.
Service Parts Inventory
Service parts inventory includes modules, components, and elements that will be used to replace the original part. An example of this would be if a consumer purchased a separate brass coupler for a hose.
Finished Goods Inventory Finished goods inventory is shippable inventory ready to be delivered to distribution centers, retailers, wholesalers, or directly to customers. An example would include the hose assembly.
Slide 13: Purpose of Inventory If supply were equal to demand, there would be little need for inventory. Goods could be made at the same rate as demand, and inventory would not build up. For this situation to exist, demand would have to be
predictable, stable, and relatively constant over a long period.
Demand for most products typically is neither predictable nor constant enough; therefore, inventory is
maintained to decouple supply from demand. Raw material is consumed, and value is added during the production operations. The output of the production operations represents stored capacity. The use of that stored capacity is limited because the raw material has been converted into a specific configuration that
cannot be used to make other products. In most cases, some inventory is necessary, but how much is an essential question. For example, when we
purchase from a vendor, the material might only be available in large containers, but manufacturing requires only half that for a particular batch of product. Therefore, the batch is kept in raw material inventory
until the next requirement from manufacturing is received. Similarly, end items are manufactured in a batch but sold individually. The finished goods inventory is then the buffer between manufacturing and the
customers.
Slide 14: Functions of Inventory Introduction Inventory performs five basic functions.
Transportation Inventory Transportation inventories represent goods that exist because of the time needed to move them from one
location to another, such as from a plant to a distribution center or a customer. The in-transit inventory can be reduced by using faster transportation or moving the facilities closer together, but there are additional costs associated with both of these alternatives. Transportation inventory is frequently referred to as
in-transit, transit, pipeline, or movement inventory. It represents the minimum amount of inventory in the system.
Lot-Size Inventory Lot-size inventory represents goods that are maintained because they cannot be acquired in precisely the amount needed. The average lot-size inventory is one-half the quantity that is acquired at one time. Lot -size
inventory is sometimes referred to as cycle stock. Fluctuation Inventory
Fluctuation inventory represents goods maintained to protect against supply, demand, or lead-time variation. If demand or lead time is greater than the forecast, a stockout will occur. Fluctuation inventory is carried to protect against this possibility. Its purpose is to prevent disruptions in manufacturing or customer
deliveries. Fluctuation inventory is often referred to as safety stock, buffer stock, or reserve stock. Anticipation Inventory
Anticipation inventory represents goods maintained to accommodate planned changes in supply and demand or lead time.
For demand changes, anticipation inventory protects against a general increase in demand, planned sales promotions, or seasonal increases in demand. Inventory built up to smooth production in anticipation of seasonal increases in demand is referred to as seasonal inventory or seasonal stock.
Hedge Inventory Hedge inventory represents the goods maintained as a buffer against some event that may or may not
Slide 16: Lesson Summary In this lesson, you discovered that aggregate inventory management typically deals with groups of items in
monetary terms. It establishes overall target levels and implements the controls needed to ensure meeting the targets.
You also explored how item inventory management deals with the individual items in both physical and monetary units and determined how it addresses these questions:
Which items are most important?
What is the appropriate level of control for an item?
How much should be ordered at one time?
When should a replenishment order be placed?
Slide 17: Lesson 2: Examine the ABC Principle
Slide 18: Lesson Introduction This lesson introduces you to the Pareto principle and examines how it is associated with the ABC principle of analyzing inventory to establish the level of control appropriate for each individual item since not all inventory items are equal.
After completing this lesson, you should be able to:
Discuss the concepts that support the Pareto principle.
Identify the basic elements of the ABC principle.
Explain how items are classified using the ABC principle.
Explain how the ABC principle applies to item control.
Follow the steps for performing an ABC analysis.
Slide 19: Pareto Analysis Another way to classify inventory is to establish the relative importance of items to the organization. This is done by applying the Pareto analysis to the inventory.
Vilfredo Pareto was an Italian economist who studied the distribution of wealth in Milan. He found that 20% of people controlled 80% of the wealth. Eventually, Pareto expanded his investigation and found that , in general, effects are created by relatively few causes. This concept led him to develop the 80 -20 rule, or the
Pareto principle, which states that 80% of the effects are caused by 20% of the events. For example, if a company has 1,000 stock keeping units (SKU), it should concentrate on the top 200 items,
as they represent 80% of the value. When there are limited resources, performing a Pareto analysis can be the most efficient way to determine how to manage item inventory. This allows an organization t o concentrate its efforts on items that have the greatest contribution to the outcome or results.
Slide 20: An Overview of the ABC Principle The ABC principle is derived from the Pareto principle and is based on the observation that a small number
of items often dominate the results achieved in any situation. When applying this in a business environment, the items in inventory representing the largest investment should be tightly controlled, and then the many items where fewer dollars are spent can have looser controls imposed. The general steps for performing an
ABC analysis are:
Select the item characteristics that are to be used to establish relative importance.
Classify the items based on selected criteria.
Apply the appropriate degree of control.
Item characteristics are usually selected based on annual financial usage, which is the value of the item multiplied by the quantity used per year. Annual usage in monetary units will be the classification that is
used throughout this course. However, the method chosen by an organization is based purely on what makes sense for its overall operations. This could include annual usage, criticality or scarcity of the component, unit cost, or velocity.
Slide 21: ABC Principle: Item Classification Once the characteristics are established, the items are classified based on the selected criteria. For example, using annual usage in monetary units as the characteristic, the items are arranged in descending
order based on the value of the item used per year. The items are then typically assigned to three groups labeled A, B, and C.
Items that are classified as A items represent 20% of the inventory and 80% of the value.
Slide 22: ABC Principle: Item Control From a control perspective, the most important items might be ordered to exactly match customer needs, while the least important are ordered in quantities to cover six months of expected usage. In addition, the most valuable items are maintained in a controlled location, while the least important are stored where
everyone has access to them. As well, the most important items might be issued in the exact quantity needed, while the least important
items might be issued in bulk. The inventory records for the most important products, or A items, might be verified once a month, while the records for the least important items, or C items, might be verified once a year.
Slide 23: Steps for ABC Analysis The steps in classifying items using the annual usage in monetary units include:
Determine the annual unit usage for each item, which could be based on customer orders and a forecast. This is exhibited in column (b).
Calculate the annual value for this exercise by multiplying column (b) by column (c). The results are recorded in column (d).
List the items in descending sequence of the annual usage in monetary units from highest to lowest
Calculate the cumulative annual usage in monetary units and as a percentage, as shown in column
(e) and column (f).
Calculate the cumulative percentage of items as shown in column (g) by dividing 100 by the total number of items.
Assign items to A, B, or C classifications based on the percentage of annual usage in monetary
units, as shown in column (h).
Slide 24: Steps for ABC Analysis (Cont.) In the ABC analysis example, 20% of the items represent 78% of the overall value and are classified as A items. The next 30% of the items represent 17% of the overall value and are classified as B items. The final
50% of the items represent 5% of the value and are classified as C items. This example closely reflects the guidelines established for the ABC analysis. In reality, though, you may need to establish some type of subjectivity for your analysis to determine an appropriate breakdown among A, B, and C items.
Slide 25: Check Your Understanding
Slide 26: Lesson Summary In this lesson, you discovered how ABC analysis is used to group items based on one or more important characteristics and showed that control is applied based on the grouping of products. ABC analysis states
that 20% of A items account for 80% of the value usage, 30% of B items account for 15% of the value usage, and 50% of C items account for 5% of the value usage.
You also identified the steps in ABC analysis from determining the annual usage, in units, for items all the way to assigning an A, B, or C classification to the items.
Slide 27: Lesson 3: Control Inventory with Proper Storage and Tracking
Slide 28: Lesson Introduction The physical and financial control of inventory requires determining where to store inventory and how to organize and control the storage areas.
These choices are important because there are many benefits that result from making good inventory control decisions. These benefits include the ability to provide timely customer service, inventory items that are easy to locate, minimal physical effort and costs due to moving goods into and out of storage, efficient
production control, and accountability within the organization, especially for the individuals directly involved in inventory management.
To be effective, inventory control needs to be enforced throughout the company by upper management. The message that must be communicated is that inventory accuracy is everybody ’s responsibility.
After completing this lesson, you should be able to:
Discuss the advantages of two types of inventory storage systems.
Explain the fixed and random inventory location systems.
Describe the wall-to-wall inventory tracking system.
Describe the perpetual inventory tracking method.
Recognize a perpetual inventory record.
Explain the requirements for effective and efficient inventory storage and tracking.
Slide 29: Dimensions of Inventory Storage Introduction There are three dimensions to inventory storage decisions, including:
Where to store the material.
How to organize the storage area.
How to control the storage area.
Inventory can be stored and organized in an area designated solely for that purpose, which is called central storage, or near the location where it will be used, which is called point-of-use storage. Alternatively, a blend of the two methods can be utilized.
Central Storage Central storage entails inventory being stored all in one location. The advantages of central storage include:
Specialized storage can be used.
Inventory is easier to control.
Inventory record accuracy is easier to maintain.
Safety stock can be reduced because it can be kept in one location.
Point-of-Use Storage
Point-of-use storage involves inventory being stored close to where it will be used. The advantages of point-of-use storage include:
Material is easily accessible.
Material is accessible at all times.
Materials handling can be reduced.
Central storage costs can be reduced.
Slide 30: Inventory Location Systems Introduction
When designing a storage area, the overall objective is to ensure optimal utilization and efficiencies. There are two basic systems for assigning specific locations to individual stock items: fixed location and random
Fixed Location In this situation, a relatively permanent location is assigned for the storage of each item. No other goods are stored in this location. This method does not fully utilize space, but it does make it easy to remember in what
general area items are located. Therefore, a locator file is not required, and the locations can be assigned based on frequency of access.
In most situations, a fixed location means that products can be located and retrieved faster and less information processing is required from a systems standpoint. This type of storage system is most practical in situations where space is not an issue.
In fixed location storage areas, companies need to allocate enough space for each item to hold the maximum quantity that is expected to be stocked. However, overflow storage can also be used to avoid this
allocation of storage space. Random Location
In this storage system, parts are placed in any appropriate available position at the time of receipt. The same SKU can be stored in several locations. This type of system typically relies on computer systems to keep track of physical locations of items. The cost of the computer system is offset by better space
utilization and faster access and retrieval. This storage system is also known as a floating inventory locat ion or a floating storage location.
For example, a distribution warehouse could use random location storage, as it has adequate space and efficient systems to support this type of storage.
It is also possible to use a combination of both methods. There may be a fixed location for a category of goods based on some type of characteristic. However, within the fixed location, random location storage in the form of a freezer might be used for products that need to be stored at a certain temperature.
Slide 31: Inventory Tracking Systems: Wall-to-Wall There are two fundamental approaches to tracking inventory: wall-to-wall inventory and the perpetual inventory record.
The inventory tracking system and the inventory accounting system are closely linked and must be consistent. The purpose of the inventory accounting system is to accurately maintain the value of inventory. The inventory accounting system includes the inventory valuation method.
A wall-to-wall inventory tracking system is a technique in which material is received into a facility and processed into the finished product without having entered a formal stocking area. The normal inventory
record of a part or product is kept only at the plant level. With standard containers and specific part numbers found only in limited places, it is easier to find any part that is in active production. Limited work -in-process within the plant eliminates much of the complexity regarding inventory control.
Slide 32: Inventory Tracking Systems: Perpetual Each transaction that affects the location or quantity of an item is reported and a new balance is computed when a perpetual inventory tracking method is used. The record of those transactions and the resulting
balance is referred to as a perpetual inventory record. The following transactions are typically reported in a perpetual inventory system:
Inventory receipts
Inventory issues
Inventory returns
Inventory adjustments
Inventory movement If an organization requires lot control for regulatory or warranty purposes, then a perpetual inventory system
should be used. Using this type of system is beneficial for the organization because it provides a full transaction history that allows you to track where each lot came from and where it went.
Slide 33: A Perpetual Inventory Record Example Let’s explore an example of a perpetual inventory record.
Permanent information is shown at the top of the record and can include items such as the part number and description, order quantity, order point, lead time, and storage location. Although not permanent, this
information does not change frequently. Any modification made to a record is usually the result of engineering changes, manufacturing process changes, or inventory management changes.
Variable information, as shown in the bottom of the inventory record, changes with each transaction and is based on the needs of the organization and the particular circumstances. This information includes the date, quantities (ordered, received, and issued), balance on hand, inventory allocated to an order, and
available balance. Inventory issued could be the result of material being returned to a supplier or an adjustment to the record.
In addition, when material is allocated to an order, only the available balance is reduced, as the on-hand material remains the same until the inventory is issued to an order.
Slide 34: Proper Inventory Storage and Tracking Effective and efficient storage of inventory requires a number of elements, including:
A good part-numbering system and a simple and well-documented transaction system.
Individuals that are committed to the process.
Clearly designated, identified, and protected storage areas.
Slide 36: Lesson Summary In this lesson, you determined that inventory can be stored in a central location or near the point of use.
Additionally, you discovered that storage areas may have a fixed location for each part or each part may be placed in any available location when it is received. Finally, you reviewed methods for effective and efficient inventory tracking and storage.
Slide 37: Lesson 4: Control Inventory with Record and Valuation Accuracy
Slide 38: Lesson Introduction Procedures need to be implemented to verify the accuracy of inventory records and to determine the value of the inventory. In this lesson, we will review the choices that an organization must make regarding these
areas. After completing this lesson, you should be able to:
Explain the importance of verifying inventory balances.
Discuss audits as a means of verifying inventory balances.
Discuss the fundamentals of taking a periodic inventory.
Discuss how cycle counting is used to control inventory.
List the steps involved in conducting a cycle count.
Identify other opportunities for cycle counts.
Examine several inventory costing and evaluation methods.
Slide 39: Verifying Inventory Records Regardless of the inventory record-keeping method, it is necessary to verify the inventory balances.
Verification of inventory balances can be performed for external reporting purposes to ensure that what the records state match what you have in the stockroom or to determine when to replenish.
The verification of inventory records involves communicating responsibility and accountability throughout the organization. With management leading by example, process and control changes that consider and solidify the verification process become an integral part of the attitude within an organization.
There are three methods of verifying the inventory balances:
Slide 40: Audits Audits are used to spot-check balances and provide a snapshot-in-time measure of inventory accuracy based on count results of a sampling of inventory. Therefore, the primary purpose of an audit is to
determine accuracy level. For example, a location audit verifies the balances of all items stored in a specific inventory location.
Slide 41: Periodic Inventory Fundamentals When a periodic inventory is employed, a physical inventory is taken on a periodic basis. Company policy determines whether the inventory is performed annually, semi-annually, quarterly, or monthly. Typically, an
annual inventory is used for financial reports, but inventories can be done at any recurring interval. The physical inventory process is frequently used to satisfy owners and auditors that the financial value of the inventory is properly stated, and it involves counting all existing inventory items. For material planners, the
physical inventory represents an opportunity to correct any inaccuracies in the records. Typically, all production and stockroom activity is suspended during the physical inventory and
reconciliation process. Usually, a physical inventory will occur during a period of time when the overall activity of an operation is at a low point.
In most organizations, a physical inventory occurs at year-end, during an annual holiday shutdown, or when production is at a minimum. The responsibility for taking the physical inventory usually resides with the materials manager, who should ensure that a good plan exists and is followed. Three key factors involved in
a physical inventory include good housekeeping, proper parts identification, and properly trained employees.
Slide 42: Periodic Inventory Fundamentals (Cont.) The steps involved in conducting a periodic inventory include:
Count the items and record the count on a ticket.
Place the ticket with the items.
Verify the count by a complete recount or by a sample record.
Collect the tickets and list the items in each location or department.
Reconcile the differences between the physical count and the inventory records.
Slide 43: Principles of Cycle Counting A major function of management is control. Cycle counting is a system used to control inventory by counting inventory continually throughout the year. The counts are scheduled so that each item is counted on a predetermined schedule. In addition, the count frequency is based on the number of items in inventory and
the desired level of control, which is based on the level of importance and the overall value of the product. Cycle counting is typically a significant and ongoing responsibility, while the physical count is a periodic interruption of the individual’s real job.
Individuals performing the counts are well-trained.
Slide 44: Principles of Cycle Counting (Cont.) An effective cycle-count program incorporates procedures to identify and eliminate the root causes of error. The number of items in inventory and the desired level of control are factors in establishing the count
frequency. One of the simplest methods of managing the cycle-counting process is to classify the inventory according
to its importance. The ABC classification usually drives the number of times a particular item is counted on an annual basis.
For example, A items require tight-control and are counted 12 times a year; B items require medium control and are counted four times a year; and C items require minimal control and are counted only once each year. To ensure that inventory is reconciled between the perpetual balance and the books, all items are
counted at least annually, which should comply with the financial requirements established by the firm.
Slide 45: The Cycle-Counting Process The steps involved in conducting a cycle count include:
Assign a count by the ABC classification.
Count the items as frequently as their classification requires.
Conduct a blind count on the initial count.
Recount the variances.
Investigate the variances.
Approve the count sheet.
Slide 46: Additional Opportunities for Cycle Counting When cycle counting is employed, items are counted at the specified frequency. However, there are other opportunities for counts, including:
When the on-hand balance is zero or negative, there should be minimal inventory to count. In addition, if inventory appears as a negative, an error within the inventory management system has occurred.
If the item is in the process of being reviewed for replenishment, this indicates that the current level is at a low point. Therefore, fewer inventories exist to count.
When an order is received for a particular item, it might be a good opportunity to review the inventory record.
If an error is detected, cycle counting helps find the root cause and correct the problem.
When a predetermined number of transactions have occurred, then the cycle counting process can be used to compare between book and actual inventory.
Slide 47: Determining the Value of Inventory The last step in controlling inventory is to determine the value of inventory transactions and balances. The accounting or finance function makes two decisions that affect the value of inventory: the product
costing method and the inventory evaluation method. The product costing method determines the cost of each unit of an item that is produced, and the inventory evaluation method determines how units of a specific item are assumed to flow into and out of inventory.
Different costing methods include:
Actual costing—The actual production costs are captured by lot or unit, and that cost is transferred
into inventory at the time of receipt of the unit and out of inventory at the time the unit is issued.
Process costing—The actual production costs are collected by period and averaged over the units produced that period.
Project costing—The actual production costs are charged to specific project phases, deliverables, or elements. No costs are transferred into or out of inventory.
Standard costing—A target or standard cost is established periodically and that standard cost is
transferred into inventory at the time of receipt and transferred out at the time of issue.
Variable costing—Only the variable costs of production are charged to the product, and that variable cost is transferred into inventory at the time of receipt and transferred out at the time of issue.
Slide 48: Determining the Value of Inventory (Cont.) Inventory evaluation methods include:
Actual—Typically used with the actual costing method and when receipts and issues are for a
specific lot or unit. This method requires lot or serial number control of inventory.
First in, first out (FIFO)—Assumes that the first unit of an item that was received into inventory is the first one that was issued.
Last in, first out (LIFO)—Assumes that the unit of an item that was most recently received into inventory is the first one that was issued.
Standard costing—Assumes that all items have equal value and the order of receipt and issue is not important.
Slide 49: Check Your Understanding
Slide 50: Lesson Summary In this lesson, you identified two ways to track inventory: wall-to-wall and perpetual inventory systems. You
also examined how inventory records must be verified on a regular basis, as well as the two primary methods for verifying inventory records: periodic physical inventory and cycle counting.
In addition, you explored how an effective cycle-count program includes procedures for identifying and eliminating the root cause of errors.
Slide 52: Lesson Introduction Inventory planning helps an organization determine how much to order at one time and when a replenishment order should be placed.
Before a determination can be made, several factors must be reviewed, including inventory -related costs, the desired level of customer service, the feasibility of perpetual and periodic reviews, the optimization of
carrying costs, and the various lot-sizing techniques. After completing this lesson, you should be able to:
Identify costs typically used in inventory decisions.
Identify the factors that have a role in determining the quantity of safety stock.
Identify methods that help determine when to place a replenishment order.
Discuss two additional fundamental approaches to placing a replenishment order.
Explain a fixed-interval review system.
List the factors to consider when calculating the order point.
Explain the characteristics of a visual, two-bin system.
Discuss how to determine the order point using a perpetual inventory system.
Explain how balancing the ordering costs and inventory carrying costs helps determine order
quantity.
Discuss some commonly used lot-sizing methods.
Slide 53: Inventory-Related Costs Introduction
Several inventory-related costs are used for inventory decision making. Item Cost per Unit
Item cost per unit is the sum of direct material, direct labor, and the overhead associated with the manufacture of a product.
For example, the costs associated with manufacturing a tractor are direct material of $300, direct labor of $180, and an overhead of $260, for the total cost of $740. In comparison, the item cost of a purchased component is the landed cost—the total cost of the component when it arrives on the manufacturer’s dock.
The landed cost of a printed circuit board includes the cost of the component, freight, duty, and taxes.
Cost of Carrying Inventory
The cost of carrying inventory is the sum of all costs incurred because inventory is held. It is commonly referred to as the carrying cost.
The carrying cost associated with an item is usually defined as a percentage of the euro or dollar value of the total inventory per unit of time, which is generally a one-year period.
Cost of Placing an Order The cost of placing an order is the sum of all costs incurred because a production order or purchase order is placed. It is commonly referred to as the ordering cost.
It includes:
The clerical work of preparing, issuing, tracking, and receiving orders.
The physical handling of goods.
Inspections.
Machine setups.
The costs of ordering inventory are usually stated as a monetary amount that is allocated over the quantity of inventory ordered.
Costs of Not Having Needed Inventory The costs of not having inventory when it is needed are also known as a stockout costs. It includes:
Expediting costs.
Freight premiums.
Back-order processing.
Capacity-Related Costs
Capacity-related costs are related to increasing or decreasing capacity in a medium- to long-range timeframe as a result of inventory decisions. They are sometimes referred to as capacity-associated costs.
Capacity-related costs include:
Personnel costs such as hiring and training, which are increases, and terminating employees, which are decreases.
Effects of change on morale.
Equipment and tooling purchases.
Change in overhead absorption due to the capacity change.
Typically, many of the elements of ordering, carrying, and capacity -related costs are difficult to quantify and estimates are used.
Safety stock is a quantity of stock kept in inventory to protect against unexpected fluctuations in supply or demand. It is maintained to provide a high level of customer service. Safety stock is usually carried at the finished goods level. However, safety stock can also be carried to compensate for scrap or obsolete parts.
For example, hard-to-get parts are carried as safety stock to guard against unreliable supplier deliveries.
The amount of safety stock required depends on several factors.
Desired Service Level The service level is a measure of how well the firm meets customer demand in terms of date and quantity
from stock for or by the current production schedule. It is typically stated as a percentage of the demand. A desired service level of 50% requires no safety stock. However, a desired service level of 90% requires a
significant investment in safety stock. It is not possible to maintain enough safety stock to ensure a 100% service level. Regardless of the amount of safety stock, there is a very small possibility that an order for one more unit than is stocked could be placed.
Variability of Demand The greater the variability of demand, the higher the level of safety stock required to compensate for that
variability. For example, sales may average 50 units per week for an item. However, due to the randomness of customer order intakes, demand for one week may be 40 units and the following week, it could be 60 units. Safety stock must cover these fluctuations in demand.
Replenishment Lead Time The length of replenishment lead time must also be considered in the calculation of the level of safety stock.
The longer the replenishment period, the higher the level of safety stock required to cover the variability of demand during the time between placing the order and the time that the goods are available. If the replenishment lead time for an item is six months, a higher amount of safety stock is needed to protect
against uncertainty than if that item had a six-week lead time. Frequency of Replenishment Orders
The frequency of replenishment orders also has an effect on safety stock. The risk of a stockout occurs when inventory is at its lowest level, which is typically just before a replenishment order is received. The higher the frequency of replenishment orders, the more exposures there are to stockouts. This concern
must be balanced with the replenishment lead time. If shipments for a particular item arrive on a daily basis, less safety stock is needed than if the item arrives only once a month, even though there are more exposures to running out of stock.
Slide 55: The Classification of Order Systems There are many ways to determine when to place a replenishment order. Think of your own replenishment of food, clothing, and fuel. How do you determine when to replenish food in your pantry or fuel in your
vehicle? Do you use the same method for everything you stock?
The determination of your ordering system should be based on whether the goods are pushed through the system to meet a plan or are requested only when replacing items that have been used or are needed for a
specific use. A specific technique is classified, or categorized, as either time- or quantity-based and as either a push or
pull technique. Time-phased methods or systems project the inventory levels and required replenishment actions over a
planning horizon. Action is triggered by the passage of time and the responsible individual acts on a system-generated recommendation. Material requirements planning and the time-phased order point are time-based methods.
Slide 56: Periodic Review Systems Introduction There are many methods for determining when to place a replenishment order, but they typically fall into one of two fundamental approaches.
Fixed-Order Cycle Inventory Model In the fixed-order cycle inventory system, a replenishment order is placed at specified intervals of time. The
order quantity is variable and must cover the expected demand through the replenishment lead time. A maximum inventory level is established based on experience, budget, or targeted inventory levels.
The order quantity is the difference between what was used during the period and the maximum inventory. For example, if 700 units are on hand, and the maximum targeted-inventory level is 2,000 units, the order quantity is 1,300 to replace the items shipped during the period.
This model is also known as a periodic-order quantity review system, time-based order system, or fixed-interval order system.
Fixed-Order Quantity Inventory Model A fixed-order quantity inventory model is a form of an independent-demand item management model. A
replenishment order for a fixed quantity is placed whenever the stock on hand plus the quantity on order reaches a predetermined level called the order point. For example, a grocery store will order 500 units of an item when the inventory on hand and on order reaches 200 units.
This model is also referred to as a fixed-order quantity system, an order point/order quantity system, and a lot-size system.
Slide 57: Fixed-Interval Review Systems The fixed-interval review system is a hybrid of the fixed order cycle and fixed order quantity systems. Items are reviewed at fixed intervals. Orders are not placed, though, unless the on-hand quantity plus on-order
quantity reach a predetermined level. Therefore, the actual order quantity varies from order to order based on how many units have shipped. A maximum inventory level is established based on experience, budget,
The order quantity is the difference between what was used during the peri od and the maximum or targeted inventory. For example, if 500 units are on hand and the maximum-targeted inventory is 1,500 units, the order quantity is 1,000 to replace the items shipped during the period.
These methods all strive to have inventory on hand at all times and are most appropriate for items only associated with independent demand.
Slide 58: Factors in Order Point Determination Several models exist to calculate the order point and answer the question of when to order. When calculating the order point, there are four factors to consider, including:
The length of time needed to replenish the item.
The average demand during the order replenishment.
The variance in the demand pattern and the delivery time.
The level of customer demand that will be satisfied.
Material requirements planning is frequently used to determine when to place a replenishment order for items with dependent demand.
Slide 59: Visual Review Systems One method of determining when the order point has been reached is the visual review system. This entails
walking up and down aisles of inventory, visually scanning, and if necessary counting on -hand inventory to determine order quantities.
A visual signal system is often referred to as a two-bin system. It has several primary characteristics.
Inventory is kept in two containers.
An active container is used to satisfy demand.
A second container has enough inventory to cover the expected demand through lead time plus safety stock.
When the active container is empty, the replenishment order is placed.
When the replenishment order is received, the second container is filled and any remaining quantity
is put in the first container.
Pull signals are a variation of the two-bin system.
The two-bin system is used frequently for low-value items that are stocked on the manufacturing floor.
Slide 60: The Order Point Using a Perpetual Inventory System Another method used in determining when the order point has been reached is the perpetual inventory system. Order point is synonymous with reorder point, statistical order point, and trigger level. In this
system, inventory levels are reviewed and all orders are placed at one time, often for all items in stock, to
replenish the inventories to a specified target level.
The formula used to calculate the order point is: Order point = Expected demand through replenishment lead time + Safety stock.
With the order point system:
Order quantities are usually fixed.
The order point is determined by the average demand during replenishment lead time.
Intervals between replenishments are not constant but vary depending on the actual demand during the order cycle.
The average inventory is the safety stock plus one-half the order quantity.
Slide 61: Balancing Inventory Costs Introduction Determining how much to order at one time involves balancing the ordering costs and the carrying costs. The total cost curve, representing the ordering costs plus the carrying costs, is relatively flat around the
point of the lowest total cost. If the organization wants to reduce lot -size, it must reduce the ordering costs or increase the carrying costs.
Whether decreasing or increasing carrying costs, the total cost curve will be lower and flatter for the entire quantity range. Conversely, increasing the ordering cost or decreasing the carrying cost will make larger order quantities appear more attractive.
Reduce the Ordering Costs Reducing ordering costs lowers the starting point for that portion of the total cost curve, making the ordering
cost lower at any point. Ordering costs that can be reduced include:
Production control costs.
Setup and teardown costs.
Lost capacity costs.
Purchased order costs. Increase the Carrying Costs
Increasing carrying costs reduces the slope of the curve. Carrying costs that can be increased include: Capital costs—This includes money that is invested in inventory that is not available for other uses
and as such represents a lost opportunity cost.
Storage costs—This includes the space, workers, and equipment related to the storage of inventory.
Risk costs—This includes risks associated with carrying inventory, such as obsolescence, damage, pilferage, and deterioration.
There are three key points to take into consideration when balancing inventory costs:
There is an order quantity in which the sum of the ordering costs and carrying costs is at a minimum
called the economic order quantity (EOQ). However, the order quantity can deviate slightly from this point with cost optimization still remaining within balance.
This EOQ occurs when the cost of ordering equals the cost of carrying.
The total cost varies little for a wide range of lot sizes around the EOQ.
Slide 63: Lot-Sizing Methods Introduction Several commonly used lot-sizing methods exist.
Lot-for-Lot The lot-for-lot method recommends ordering the exact amount required to meet the demand and cover safety stock quantities and generally results in no residual inventory. The order quantity changes whenever
requirements change. This is appropriate when the item has a high cost or short shelf life or when demand is low or intermittent.
Fixed Quantity The fixed quantity method involves ordering the same quantity each time an order is placed. This is also referred to as the nice round number or fixed order quantity method. It is appropriate for C items and when
there are package- or supplier-specified order quantities. This method usually results in excess inventory. Fixed-Period Quantity
The fixed-period quantity method is also known as fixed periods of supply. It sets the order quantity equal to the requirements for a given number of periods. The order quantity changes whenever requirements change, and there is no planned residual inventory. This method has the advantages of the lot -for-lot
method and allows for aggregation of requirements to spread the cost of ordering over more units. EOQ
The EOQ method is used when the demand is relatively constant and known and the item is produced or purchased in lots or batches, not continuously. Additionally, order preparation costs and inventory carrying costs are constant and known and replacement occurs all at once.
The EOQ method is based on a mathematical calculation of the point on the total cost curve where the ordering and carrying costs are equal. This is the lowest unit cost point and can be precisely calculated.
However, the total cost curve is relatively flat near that point, and the precision may border on absurdity.
Slide 64: Check Your Understanding
Slide 65: Lesson Summary In this lesson, you reviewed how much inventory should be ordered at one time and when replenishment orders should be placed. You also examined how safety stock is maintained to provide customer service, despite the variability in supply and demand.
In addition, you explored the characteristics of the fixed-order cycle model and the fixed-order quantity
model, and you identified the formula for determining the order point. Finally, you identified that determining how much to order at one time involves balancing the ordering costs
and the carrying costs and dictates the type of lot-sizing method that is utilized.
Slide 66: Course Summary Properly controlling inventory is a critical task for your organization’s profitability. In this course, you
examined the concepts, terms, and procedures of inventory management. For a better understanding of inventory control, you used the ABC principle to establish an appropriate
system for grouping items. You also determined how to control inventory through proper storage and tracking techniques. In addition, you recognized the importance of record accuracy and correct inventory value. Finally, you considered the factors for planning inventory levels and replenishment.
Implementing the appropriate tools for inventory planning and control can help your business avoid stockouts and excessive costs for carrying inventory while improving overall efficiency.
